The cruel choice between two evils, unemployment and inflation, has become the major economic issue of the day. Democrats and Republicans agree that both evils must be avoided and differ only on the means—with Democrats largely favoring the more drastic remedies. Congress has thrust upon the President authority for direct controls on wages and prices. The Administration has relied on traditional fiscal and monetary measures, including changes in taxes and spending and Federal Reserve control over the supply of money. First it tried to hold down prices by using tight money to restrain demand; now it is trying to create jobs by using budget deficits and easier money to expand demand. But the results, so far, are not encouraging. The traditional measures produced a recession and rising unemployment, but inflation hardly slowed down. Now both the recession and the inflation seem very stubborn.
Nevertheless, inflation and recession are usually alternative afflictions. One of the most dismal and best verified observations of modern economics is that there is ordinarily a trade-off between the rate of inflation and the rate of unemployment. Less of one means more of the other. Hence, full employment (which means an unemployment rate between 3 1/2 and 4 1/2 percent) can, on the average, be sustained only with 4 to 5 percent inflation. Price stability (another Pick-wickian term, meaning annual inflation of no more than 1 to 2 percent) is possible only with more than 5 percent unemployment.
The basic explanation for this trade-off (known to economists as the “Phillips curve”) is that, when business is booming and unemployment is low, labor and management can claim wages and profits which add up to more than 100 percent of the value of output they produce at current prices. Not everyone can be satisfied without a rise in prices. Inflation is a peaceful and anonymous resolution of these inconsistent and conflicting claims. When unemployment and excess productive capacity are high, claims for higher wages and profits are checked by actual or potential competition. But it would take a virtual depression to stabilize prices altogether.
One reason for the inflationary bias of our economy is that strong unions and corporations are insulated against the pressures of competition. But even in the competitive sectors of the economy there are powerful forces which push up prices during good times. The crucial factor is the universal reluctance to accept setbacks in money income. Wage rates for a given job can almost never be cut. Many firms would rather lose short-run profits than lower prices. The economy depends on changes in prices and wages as signals to move labor and other resources from sectors of declining demand to sectors of growing importance. But if prices and wages can never go down, there is only one direction in which they can move in response to changing economic conditions.
Although a slowdown of demand aggravates one disease, unemployment, while ameliorating the other, inflation, it does the first right away and the second with a lag. The first reaction of most businesses to disappointing sales is to cut output and employment, not to change their established price lists and wage scales. Unions do not give up hard-won wages as soon as actual or potential members become unemployed. Unemployed workers search for jobs at prevailing wages; they rarely volunteer to take a lower wage in order to get a job. Meanwhile the momentum of adjusting prices to past wage increases, and wages to past price increases, continues. The moderating effects of slack demand on prices and wages occur slowly and indirectly.
That is why 1970 was a year of both sharply rising unemployment and inflation. Today’s perverse combination of the worst of both worlds, 5 percent inflation and 6 percent unemployment, reflects the difficulty of transition from several years of rapid price increases. Continuing unemployment at current levels should eventually suffice to reduce inflation to 1 1/2 or 2 percent a year. But this would take two years or more.
Recessions aren’t good politics, as Vice President Nixon learned in 1958, candidate Nixon learned in 1960, and President Nixon learned in 1970. Through 1969 and 1970, the Administration patiently tried to manage a gradual and controlled slowdown by restricting the size of the budget deficit and the growth of the money supply. The effects on inflation were disappointing, but now the Administration has decided that the patient has had enough deflationary medicine even if his symptoms don’t yet exhibit a cure. The Administration aims to reduce unemployment to 4 1/2 percent by campaign time in 1972 by running a large deficit and holding down interest rates. Their hope is that we can meanwhile enjoy the best of the two worlds of which we had the worst in 1970. The deflationary medicine of 1970 hit employment and output, but its effects on prices were deferred until 1971-72. The expansionary medicine of 1971 will, it is argued, raise employment and output while price inflation is tapering off.
The scenario has some appeal but it is an unlikely one. First of all, the doses of expansionary policy seem inadequate. This Republican President, saying “I am a Keynesian,” has deliberately embraced deficit spending, sweetening the bitter pill for conservatives by promising to spend no more than the hypothetical revenues the tax system would produce at full employment. But in spite of all the rhetoric about the “full employment budget,” fiscal policy will be no more expansionary in 1971-72 than in 1970-71. Both federal expenditures and revenues are, according to the budget proposals, to rise at the normal rate of growth of the economy; in both fiscal years a “balanced full employment budget” is projected.
But that will not be enough to achieve full employment. For an easy money policy the President is dependent on Arthur Burns, chairman of the Federal Reserve Board, who is in no mood to validate the Administration’s forecasts and targets. Burns wants to see more evidence that inflation is abating, and he wants more direct action to control specific wages and prices than the President and George Shultz, his economic Kissinger, are willing to take.
A more likely prospect is several years of high unemployment, 5 to 6 percent, and gradually ebbing inflation. At best, we may return to the familiar situation of the late Fifties, with unemployment meandering around 5 percent because the makers of monetary and fiscal policy are afraid of the inflationary consequences of measures to restore full employment.
Is that the world we want? Five and a half percent unemployment for the nation translates into between 11 and 12 percent for the young and for blacks (and perhaps twice that for the black young). It amounts to an annual sacrifice of roughly $55 billion in unproduced output compared with the full employment level. In short, victory in the war on inflation has an enormous cost. Perhaps, instead, we should explore the path of peaceful coexistence with inflation—making it more bearable, and learning to live with it.
The first step is understanding just what harm inflation causes. Here, as elsewhere, conventional journalistic and political wisdom is a poor guide. The major charge against inflation is that it redistributes income unfairly. Supposedly, wages lag behind climbing prices and corporate profits. Old people on fixed incomes, savers, welfare recipients, and government employees are all said to suffer a severe loss of purchasing power. Inflation, the phrase goes, is “the cruelest tax of all.”
The facts tell a different story. The major gainers from inflation are workers who would have been unemployed or underemployed had prices been kept lower. This group, of course, is heavily made up of the poor and the young. A 1965 study by Metcalf and Mooney for the OEO estimated that a shift from 5.4 percent to a 3.5 percent national unemployment rate would result in an increase in full-time employment of 1,042,000 for the poor.* The net result would be to move 1,811,000 people above the “poverty line,” as it is defined by the government. Apart from its effect on unemployment, inflation neither systematically helps nor hurts the working man. There is no evidence to suggest that labor’s share in the national income—the percentage of total income paid to workers—deteriorates during periods of inflation.
Social security and welfare payments also catch up with inflation after a brief period, although they may fall short in the initial stages. Some people who save are hurt, but primarily because government regulations place a low ceiling on the rates banks and savings and loan associations can pay to small depositors. Without the ceiling, deposit rates would rise along with general interest rates. The only consistent losers from inflation are those whose incomes are fixed by preexisting contracts, especially old people living on private pensions and holders of long-term bonds. But only the former group embraces the poor—bonds are an encumbrance of the well-to-do. Over-all, our only major concern about the effect of inflation on the distribution of income should be for pensioners, and it would be much less painful to subsidize pensions than to suppress inflation.
A more fundamental problem is raised by Milton Friedman and others, who deny that we can reap the gains of high employment by choosing to live with more inflation. They argue that there is no long-run trade-off between inflation and unemployment. The Phillips curve, in their view, expresses only short-run alternatives. In the long run, there is only a single, “natural” rate of unemployment for a country’s economy. If we try to reduce unemployment beyond this point we may have some temporary success, but the resulting price increases will prod unions and other workers to raise their wage demands, while inducing employers to grant them. Once again, the sum of wage and profit claims will exceed the value of output available to satisfy them. An even higher rate of inflation will be necessary to resolve this conflict.
Moreover, Friedman argues, this new round of inflation will also, in turn, be reflected in a new round of wage demands. As a result, the Phillips curve trade-off will become increasingly worse. Where initially we might have been able to choose 3 percent inflation with 4 percent unemployment, we might soon have to accept 6 percent inflation for the same rate of joblessness. Over time, in this view, the economy cannot choose its rate of unemployment, but can merely decide how much inflation it wishes to endure in a futile attempt to alter that rate.
Friedman’s argument rests on an appealing but unverified assumption: that you can’t fool all of the people all of the time. If labor and business are making inconsistent demands, then in Friedman’s view a mere renumbering of prices and wages through inflation will not resolve the conflict. But, in fact, the evidence suggests that even sophisticated people are far more sensitive to direct losses in money incomes than to declines in their purchasing power through higher prices. Wage and salary reductions are almost unknown in industrial countries, even though it is not uncommon for employees to suffer temporary losses in purchasing power. So long as wages and prices are set in dollars, and money retains its age-old power to deceive, inflation can be used to resolve economic conflict.
C. E. Metcalf and J. D. Mooney, "Aggregate Demand Model," unpublished working paper for the OEO, 1965, cited in R. G. Hollister and J. L. Palmer, "The Impact of Inflation on the Poor," Institute for Research on Poverty discussion paper, University of Wisconsin, 1969.↩
C. E. Metcalf and J. D. Mooney, “Aggregate Demand Model,” unpublished working paper for the OEO, 1965, cited in R. G. Hollister and J. L. Palmer, “The Impact of Inflation on the Poor,” Institute for Research on Poverty discussion paper, University of Wisconsin, 1969.↩